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Improving the Adviser-Client Relationship, Part 2

by Bryan Olson, CFA, and Mark W. Riepe, CFA


Bryan Olson, CFA, and Mark W. Riepe, CFA, are head of portfolio consulting and head of the Schwab Center for Financial Research, respectively, for Charles Schwab & Co. Inc.


Successful investment advisers need to be world class at both investing and getting their clients to act upon the investment advice that is dispensed.
 
This month's column is a continuation of our piece from the December 2009 issue of the Journal, in which we discussed how advisers can use behavioral finance to improve outcomes for their clients through making and communicating useful recommendations in a way that increases the odds that the client will act upon them.
 
In December we discussed some insights of behavioral finance that pertain to establishing the adviser-client relationship and profiling the client. This month, we review the process of making recommendations to clients.
 
We describe some key findings from behavioral finance that pertain to making recommendations to clients and make suggestions for advisers about how to incorporate these findings into their practice. We don't cover every relevant behavioral finding, but instead focus on findings that (1) our experience suggests most frequently impede an effective client-adviser relationship, and (2) those where we have practical recommendations for advisers.
 
Many advisers make a mistake at this phase of the relationship because they approach it as purely a technical problem of making the best recommendations possible. We believe the goal of the adviser-client relationship is to improve the outcome for the client. Achieving that goal requires that the recommendations be expert, but also take into account the likelihood of being enacted.

Recommendation 1: Obtain Client Buy-In

Many, if not all, advisers suggest to clients that they eliminate emotion, but we make the unremarkable observation that nothing in our experience suggests that emotion is going away anytime soon. Regret is a particularly interesting emotion in the context of advising individuals on investing for four reasons.

  • Pervasiveness. We're sure every reader has felt regret when a trade's gone bad.
  • Influences decisions. Larrick and Boles found that when individuals expect to receive feedback on the forgone alternative, they will alter their behavior so as to avoid it.1
  • Frequently misleading. In some realms of human activity, regret is good because it encourages us to learn from the past. Regret as a learning tool may be less effective in financial markets where randomness is large.
  • Accountability. Regret hurts and it is only natural that individuals who feel regret try to make it go away. In the context of the adviser-client relationship, one method is for the client to blame the adviser.

The world of investment advice is fruitful ground for generating regret for three reasons.
 
 1. There are many opportunities for regret.
 2. Clear alternatives are present for each decision.
 3. Measurement is easy.

The client buy-in to which we refer involves creating a sense of joint ownership by bringing the client closer to the decision-making process. After expending the energy to present and explain recommendations to the client, an adviser will often believe his or her job is done, but seeking out objections or questions and addressing them can solidify buy-in. We advise never talking a client into a recommendation with which they are uncomfortable. It is always better to wait and seek other opportunities for more education and dialogue, rather than proceeding and risking regret.

Recommendation 2: Understand the Client's Past Investment Experiences

Investment advisers often take an investment history of their clients to gauge the clients' level of sophistication and their risk tolerance. This makes sense, but we also believe that the history of the client will influence how the current recommendations of the adviser are viewed. Advisers who make recommendations similar to those that the client perceives blew up on them in the past will have a tougher road in making the client accept the recommendation.

Recommendation 3: Understand the Ownership History of the Client's Existing Investments

The endowment effect predicts that individuals will place more value on an item merely because they own it. This effect is important for advisers to understand because there are so many instances in which clients walk in the door with pre-existing portfolios and advisers may have difficulty convincing clients to part with these holdings. Therefore, the adviser must be prepared for resistance.
 
One facet of a portfolio's history is the length of time a security has been owned. Strahilevitz and Lowenstein find, in a study using trinkets, that length of ownership is positively correlated with the price at which subjects were willing to sell the item.2 Anecdotal evidence suggests that the longer a security is held, the more emotionally attached the investor becomes and the less willing he or she is to part with it, irrespective of the investment merits for doing so.

Recommendation 4: Do Not Assume the Clients' Versions of Their History Are Accurate

Morewidge et al. asked subway passengers to recall an occasion in which they missed a train and to predict their reaction if they missed a future train.3 Those who chose to recall a single occasion recalled the worst one and predicted their experience would be equally bad if they missed a train in the future. Ask clients if the recommendation is similar to something they may have done in the past. They may have vivid memories of a past experience that could taint their perception of the current situation.

Recommendation 5: Trim Concentrated Positions over Time

If a client holds a large position in a single stock, the act of immediately selling all shares is often simply a non-starter. The endowment effect can be stronger in these situations as the concentration is often due to periods of strong past performance.
 
Selling smaller positions over time is beneficial for two reasons.

  1. Reduces regret. One big decision to unload an entire position carries the risk of major regret.
  2. Lessen the added emotional pain of taxes. The prospect of giving up some of the gain by paying taxes can amplify the endowment effect. Smaller decisions over time can lessen the tax burden at any given point and ease the emotional pain of selling.

Recommendation 6: Bundle Recommendations

"Framing" can be thought of as the context in which a decision is made and it influences the choice of the decision maker. An investor who uses a narrow frame evaluates each trading decision in isolation of the rest of the portfolio, whereas those with a broad frame evaluate each trade on its own merits, but also take into account the trade's effect on the rest of the portfolio.
 
Narrow frames are the enemy of diversification. Bundling recommendations combats narrow frames and benefits the client in two ways.

  1. Creates an educational opportunity. It is far easier to explain to the client how the recommendations work as a unified group when they are bundled together.
  2. Improves performance by combating the disposition effect. Kumar and Lim find that those who grouped trades together were less prone to the disposition effect (tendency to avoid selling securities to realize a loss and instead sell those that have gains) and built more diversified portfolios.4

Recommendation 7: Segregate "Emotional" Investments

Emotional investments are those in which the client has such a strong emotional attachment that it biases his or her objectivity. Assuming the amount of these investments in the portfolio is a relatively small percent and doesn't put the portfolio at risk, it can often be more fruitful to move beyond this by segregating this investment into its own account. This way the adviser can focus on adding value to areas of the portfolio where it will be welcomed.

Next Time

In our final installment of this series we'll discuss the final stage of the adviser-client relationship; performance evaluation and relationship renewal.

Endnotes

  1. Larrick, Richard, and Terry Boles. 1995. "Avoiding Regret in Decisions with Feedback: A Negotiation Example." Organizational Behavior and Human Decision Processes (July).
  2. Strahilevitz, Michal A., and George Loewenstein. 1998. "The Effect of Ownership History on the Valuation of Objects." Journal of Consumer Research (December): 276–288.
  3. Morewidge, Carey K., Daniel T. Gilbert, and T.D. Wilson. 2005. "The Least Likely of Times: How Remembering the Past Biases Forecasts of the Future." Psychological Science 16: 626–630.
  4. Kumar, Alok, and Sonya Seongyeon Lim. 2008. "How Do Decision Frames Influence the Stock Investment Choices of Individual Investors?" Management Science (June): 1052–1064.